Darrell Issa held a hearing in Brooklyn titled “Failure to Recover: The State of Housing Markets, Mortgage Servicing Practices, and Foreclosures.” It was filled mostly with members of the banking and regulatory community, as well as Edward Pinto of the conservative think-tank AEI. I love the “do-tank” nature of Pinto’s testimony, which states that the best thing we can do for the housing market – currently in the middle of several intense legal and regulatory disputes over allegations of systemic fraud – is to “Start by repealing the two biggest job killers – ObamaCare and Dodd-Frank.” Go Team Red!

Can’t find a transcript, but I want to get to something that I hear was said from several people. Sarah Jaffe, covering the event for Alternet, wrote “Issa made apologies for banks robo-signing (implying that they committed foreclosure fraud because they were so busy processing foreclosures they simply couldn’t keep things straight)” and Harry Bradford, covering the event for Huffington Post, wrote “Issa…[implied] that homeowners were partly to blame for banks’ reliance on robo-signing — a practice of rushing through home loans that banks used heavily in the lead up to the foreclosure crisis.”

You’ll probably hear more of that if you haven’t already. The problem with manufacturing foreclosure documents is because there are so many foreclosures, because what else could be done? It’s like the I Love Lucy episode where chocolate is coming down the conveyor belt too fast – of course Lucy is going to start rubber-stamping foreclosure documents without even looking at them when they are rolling in so fast.

It’s worth noting that the servicing system, with its green/red setup, is designed to cause these problems, in order to maximize profits for intermediaries. As Reuters has noted about this system:

Interviews, deposition transcripts and LPS’s own records underline that the company keeps its clients happy and maximizes its own fee income by whipping law firms to gallop cases through the courts.

The law firms are on a stopwatch: Kersch confirmed that the LPS Desktop system automatically times how long each firm takes to complete a task. It assigns firms that turn out work the fastest a “green” rating; slower ones “yellow” and “red” for those that take the longest.

Court records show that green ratings go to firms that jump on offered assignments from their LPS computer screens and almost instantly turn out ready-to-file court pleadings, often using teams of low-skilled clerical workers with little oversight from the lawyers. Copies of company newsletters from shortly before LPS was spun off show that the company each year gave awards to the law firms that were consistently the fastest.

Firms that move more slowly were slapped with “red” designations. For them, work offers dried up.

LPS made a series of decisions to further exacerbate this problem in a way that would increase its market domination and revenues. It gave away business free to clients and decided to generate revenue by coordinating a network of attorneys, making its money through charging them fees. It acted as a filter between clients and attorneys handling defaults, which broke the client-attorney relationship. It then created a series of incentives to maximize speed over quality.

LPS handled more than 50% of the industry’s residential mortgage volume. Their business model was designed to strip the legal work necessary for foreclosure to its bare minimum. With no market pressure from consumers — they don’t know if their mortgages will be securitized, and certainly have no say in who will be managing payments if they are — and with the default management system working to obscure cut corners and emphasizing speed over reliability or quality, it is up to the legal system to provide a necessary check.

Now, we are frequently asked what the impact on our servicing costs and earnings will be from increased delinquencies and lost mitigation efforts, and what happens to costs. And what we point out is, as I will now, is that increased operating expenses in times like this tend to be fully offset by increases in ancillary income in our servicing operation, greater fee income from items like late charges, and importantly from in-sourced vendor functions that represent part of our diversification strategy, a counter-cyclical diversification strategy such as our businesses involved in foreclosure trustee and default title services and property inspection services.

I think the most damning part of this statement is the reference to “in-sourced vendor functions.” Allegations are swirling around that servicers, and their agents such as MERS, bloat their actual costs of collection or default and build in a profit margin. This is illegal, in part, because most mortgages only permit the recovery of “costs,” which most courts read to mean actual costs incurred, not some amount chosen to “offset” the costs of servicing delinquent loans. Judge Elizabeth Magner has a recent opinion that addresses the propriety of this practice. She writes in the Memorandum Opinion in In re Stewart (07-11113, Bankr. E.D. La. April 10, 2008) that “Wells Fargo’s national counsel has represented to this Court that only $50.00 of each invoice represents the actual cost incurred by Wells Fargo fro a BPO. The remaining amounts, approximately $880.00 in total, were added to the actual costs by Wells Fargo. The Court concludes that these additional charges are an undisclosed fee, disguised as a third party vendor cost, and illegally imposed by Wells Fargo.” Her opinion, combined with the statement in Countrywide’s earnings statement, suggest that Senator Schumer may be too generous in calling servicers’ practices “piling on.” If this practice is widespread, the more apt term may be “ripping off” struggling homeowners.

Keep this in mind the next time you hear the Lucy and the Chocolate Factory theory of servicer abuse.